Pub. 7 2016 Issue 2

www.wvbankers.org 20 West Virginia Banker Creating Performance vs. Managing Risk By Chad McKeithen, Duncan-Williams, Inc. B ankers tend to be overly defensive regarding interest rate risk. We work with about 400 banks each quarter regarding interest rate risk and portfolio decisions. Since 2008, a large majority of cli- ents have maintained shorter balance sheet positions to combat higher rates. The theory is that rates will rise and they will be in an asset-sen- sitive balance sheet position. The reality is that rates have remained low, and the 8 years of reduced balance sheet risk has come at the cost of less income. Income is one of the best risk diffusers because retained earnings increase capital, one of the best buffers to long-term risk. When a bank chooses a short/ defensive balance sheet position (cash, short bonds, etc.) they are lowering interest rate risk but at the expense of future earnings and capital growth. We have become a regulatory dominated industry that many times allows risk management to supersede performance. In my 20 years working with banks in A/L and portfolio management, I have strug- gled the most with banks that take too little risk, instead of maximiz- ing return. Interest rate risk is real, and this is certainly not a declaration to throw caution to the wind. But, minus some 1980 S&L situations (30year mortgages funded with 6 month CDs), banks have typically pros- pered when rates rise. It is rare that negative market value due to rate changes has ruined any banks. Yet, a bank will see negative EVE results under a +300 basis point instantaneous shock and determine that they need to reduce interest rate risk. It’s difficult to become a high performing organization when reducing risk is the primary focus. Forecasting Risk forWest Virginia Banks How does a bank correct this and manage performance while fac- toring in risk? When managing interest rate risk, it’s not important to forecast what interest rates will do. It is extremely important to understand how your cost of funds (COF)/deposits will react to rate changes. If a bank understands this relationship, then they can maxi- mize earnings potential. One of the simplest methods to determine how sensitive your COFs are to rate changes is to run a regression analysis correlating COFs to past market rate changes. Take a look at Graph 1. This plots the period from 2004 to 2006 when the Fed increased rates by 425 basis points (blue line) against COFs in WV (green) and COFs nationally (red). This was a very rapid rate hike in a short time frame, so it is great for analyzing how sensitive COFs were. If we conclude there is a relationship, then we can apply that to future Fed expectations, and determine the ultimate costs for the bank.